Friday, June 25, 2010

It’s diffi cult, these days, arguing that the yuan is notundervalued. The widely publicized large current accountsurpluses and bulging foreign exchange reserves in Chinasuggest otherwise and continue to provide fodder tocritics of Beijing’s exchange rate policy. While today’srevaluation of the yuan was inevitable, given the necessityto rebalance the global economy, the change in Beijing’scurrency policy need not be detrimental to China.

Why Rebalancing Growth is ImportantIn fact, a revaluation of the yuan could get China to a moresustainable growth model faster. While China’s rise toexport prominence was made possible by relatively cheaplabour, the latter won’t last forever, given the rising domesticwages and the ascent of other low-cost centres (such asBangladesh and Vietnam). Note also that consumers arestill a small part of the economy relative to traditionalpowerhouses like the US, Japan and Germany (Chart 1).Strengthening its economic base by stimulating domesticconsumption further, while not relying too much on exports,is a plus for sustainability of growth. An appreciation of theyuan goes in that direction, with resources being shiftedfrom exporters to consumers who will be benefiting fromlower import prices and more choice.

Implications for TradeThe potential harm to exporters, wouldn’t be as dramaticas feared. Any appreciation of the yuan will result in aless-than-proportionate increase in the dollar price ofa Chinese product in the US. That’s because only thedomestic component of the product will be impacted(e.g. the value-added by the producer, refl ecting factors ofproduction in China). The foreign component of the price,namely the input prices (such as imports from suppliers),and US costs (like shipping, retailing, and advertising) willbe unaffected. Of course, that’s assuming that suppliercountries like Japan and other Asian nations do not lettheir currencies appreciate as steeply as the yuan againstthe US$, a reasonable assumption given policies duringthe last yuan revaluation.

Numerous studies1 have noted that the domestic contentof Chinese exports is between 35-55%. Even assumingthe upper-bound of that range, a yuan revaluation ofsimilar magnitude to the one seen from July 2005 toJuly 2008 (i.e. 17% appreciation) would, at worst, raisethe price of imports from China by 9%, not signifi cantenough to cripple China’s overall exports, especiallyconsidering that any appreciation will be spread out overseveral years.

That might explain why China coped well the last timethe yuan was revalued. Trade remained relatively healthyduring the 2005-2008 unpegged period, with exports toAsia nearly doubling and sales to North America soaring70%, while exports to other regions were even moreimpressive, helped by the yuan’s competitiveness (Chart2). If history is any guide, a small appreciation is unlikelyto have major detrimental impacts on China’s exportmarket share.

The government of India has come out with a revised draft of the DirectTaxes Code (DTC) that proposes several changes over the first draft to dealwith some of the major concerns raised in the first draft. It is open forpublic comments till June 30,,2010. The proposed changes in the reviseddraft, its impact and our views are mentioned herein below.

􀂃 MAT to be calculated on book profits as compared to gross assetsThe revised draft suggests that book profits rather than gross assets,as proposed in the first draft, should be used to calculate the minimumalternate tax (MAT). However, the tax rate as a percentage of the bookprofits has not been specified. Under the previous draft, it had beenproposed to calculate the MAT on gross assets (0.25% for banks and2% for all other companies). However, the revised draft also does notallow for carry forward of MAT paid.

Our view: The revised provision is positive for companies that areeligible for MAT, as the calculation of MAT on gross assets, asprovided in the first draft, could have led loss-making companies,newly set up infrastructure companies and companies undergoingmajor expansions to pay very high taxes.

􀂃 Tax exemption on withdrawal for select saving schemesUnder the first draft, it was proposed that withdrawals towards savingschemes would be subject to taxation at the applicable marginal rateof tax (EET taxation). The revised draft now proposes complete taxexemption for government provident funds (GPF), public providentfunds (PPF), recognised provident funds (RPF), pension schemesadministered by Pension Fund Regulatory and Development Authority,approved pure life insurance and annuity schemes.

Our view: The provisions are marginally positive for individualtaxpayers. However, the tax exemption on withdrawals applicableonly on pure life insurance schemes is negative as unit linkedinsurance plans (ULIPS) would be subjected to tax on withdrawal.Also, it will be negative for mutual funds as withdrawal from equitylinked savings schemes would be subject to tax post implementationof DTC. The new pension scheme will, thus, have an edge over theother market related savings instruments as it will be the onlyinstrument providing equity exposure (50%) and have thewithdrawals exempted.

􀂄 Mounting inventories at the producers’ end have dashed all hopes of an early recoveryin steel prices. Steel producers, who held on to prices in April and May in the hopethat prices would recover on the back of rising costs, have lost market share to traders,who cut prices in line with the changing market reality. With diminishing hope of anearly recovery in prices, given continued production growth in China, steel producersaround the world have also begun cutting prices since the beginning of June. Howevercost increases are more certain due to recently negotiated quarterly prices of iron oreand coking coal.

􀂄 Squeezed by price cuts and cost pressure, steel producers are likely to witnessmargin contraction. In 1QFY11, margins would be hit the hardest for SAIL, followed byJSW Steel and Tata Steel India. There would be a bigger drop in margins in 2QFY11.Though Corus’ management sounded very confident about 1HFY11 earnings whenTata Steel reported 4QFY10 results, we are less confident about 2QFY11 due to thechange in market conditions post the analyst meet. However, we believe that marginswill rebound in 2HFY11, as market forces adjust steel prices and raw material costs.

􀂄 We are cutting our FY11 EPS estimates by 19% for Tata Steel, by 24% for JSWSteel, and by 26% for SAIL to factor in the margin shrinkage in 1HFY11. Based on ourrevised FY11 estimates, the three steel companies appear expensive. JSW Steel,however, appears attractive based on FY12 estimates due to expected addition ofnew capacities by March 2011. Volume growth will elude SAIL and Tata Steel in FY12.

The BFSI space, which has ~25% weightage in the Nifty, lifted the indexin the recent rally from the lows of 4700. Within the banking space, wesaw midcap banks taking the cream of the rally on takeover andrecapitalisation buzz. The credit growth in the system has started topick up pace. It grew by 19.1% while deposit growth moderated to14.3% for the fortnight ended June 4th. Banking sector stocks haveoutperformed the market over the past 12-15 months. PSU banks arenow trading between 1.2x and 1.8x FY12E ABV while private banks aretrading at 1.8-3.5x. Both private and public banks have led the rally inour markets from the lows of March 2009.

􀂃 What next?In our view, banking stocks are likely to move in line with markets inthe coming quarter as the first quarter is a lull season for bankcredit. We prefer banks that have sustainable NIM (high CASA, lowbulk deposits), higher RoE and growth potential in addition to lowvolatility to profitability (i.e. less dependency on treasury gains).For FY10, credit growth in the system is expected at 20% anddeposit at 18% with an upward bias. We expect the NIM for banks tostabilise. Base rate implementation is unlikely to impact thebottomline substantially. Asset quality will remain a concern for acouple of quarters more on account of slippages from restructuredassets. Most of the banks have already seen a slippage of 6-10%from the restructured portfolio so far and this is likely to inch upfurther in the coming quarter.

On the basis of the following parameters we prefer Oriental Bank ofCommerce, Union Bank of India, Punjab National Bank from thepublic sector space and HDFC Bank from the private space. We alsorecommend IDBI Bank as our contrarian pick from the coverageuniverse.

Bearing in mind the current liquidity scenario where banks are borrowingunder the LAF window from RBI and with inflation at 10.2% in May 2010,we expect rates to have an upward bias from here on. The RBI may raiseboth repo rate and reverse repo rates by 25 bps each to 5.5% and 4.0%,respectively, in the July monetary policy meet though monsoon will be akey monitorable.

Indian Tier 1 IT vendors appear to be poised for the next wave of growth, driven by the return of stable IT budgets, improved decision making at clients and higher thrust on offshoring and global delivery model. We expect multiple growth drivers over FY10-FY13E which predominantly includes underpenetrated service lines like Infrastructure managed services, BPO, Package implementation, Engineering and R&D services, as well as increasing focus on new markets like Latin America, Middle east , India and China.

Service line wise growth opportunities:a) While Remote Infrastructure management services (IMS) is a USD100bn opportunity, Indian exports from this service line stood at USD4bn for FY09, which represents just 4% penetration.

b) BPO services have already been witnessing robust traction for Indian Offshore vendors but can still count a USD130Bn opportunity as on FY09, of which Indian vendors derive just USD12.8bn as on FY09 which represents 9.8% penetration.

c) Consulting and Package implementation, which has been the key growth arenas during the 2003–2008 upcycle for Indian Tier 1 vendors still has a huge market opportunity. The ERP services market which includes ERP, SCM, CRM etc, is a USD71bn opportunity as on CY10 and the top four IT vendors derive just USD3.46bn in revenues from package implementation and consulting as on FY10.

d) Finally Engineering design and R&D services is touted as another growth arena by the Nasscom with a potential for Indian vendors to derive over USD35bn-USD40bn by 2020 as compared to USD8bn (Approx) as on FY09.  Vertical wise growth opportunities: Governments across the world spend around USD154bn on IT services and Indian IT vendors currently have a very minimal penetration in this segment. We expect Government and Healthcare verticals as strong growth opportunities over the coming period. Geographical growth opportunities: Indian vendors are fast expanding the addressable market by ramping up client base in emerging markets like Latin America, Australia, NZ, Middle East, and China. Vendors like TCS have reached critical mass in emerging geographies and are poised for further scalability.

Indian IT vendors: New growth opportunitiesInfosys Tech: Infosys appears to be banking on non linear growth initiatives as its new growth drivers. Some of the initiatives include platform BPO, Pay per use services, and Application platforms (Mobile Flypp, Shopping trip 360, Itransform).

TCS: We believe that TCS key growth drivers would be its strong geographical mix with 20% of the revenues derived from the emerging markets like Latin America, India, Australia, NZ, Middle East etc. Platform BPO also appears to be a key forte.Wipro: Wipro has strong competency in the IMS and BPO service lines, which contribute to 21% and 10.5% of the total revenues respectively for FY10. We expect these two service lines along with testing to be growth drivers for Wipro.

HCL tech: HCL Tech has well diversified service line mix with Enterprise application services, IMS, and Engineering design services, which account to 21.4%, 22%, and 19% of the total revenues and could be strong growth drivers.

We expect India to see an investment of Rs 27tn in infrastructure developmentover the 12th plan period (FY13-FY17); 65% of this investment is estimated tobe in sectors like power, roads, and railways. This development will offer~Rs 12tn of EPC opportunity to construction companies. The Private sector islikely to account for 39% of the total spend. Overall debt funding of Rs 14tnmay not be a constraint if the proportion of infrastructure credit to total bankcredit continues to rise moderately each year. Key risks include delays in coalavailability (power capex) and road project award activity by NHAI, and slowexecution of railway projects. Within our coverage universe, we prefer L&T,IVRCL, NCC, Patel Engineering and Ahluwalia Contracts and recommendbuying these stocks for long-term value creation.

Expect infrastructure investments of Rs 27tn over 12th plan period: We estimatean infrastructure investment of Rs 27tn, up 32% over government’s revisedestimate of Rs 20tn spend for the 11th plan. We expect the government (centreand state) to account for Rs 16.5tn of the spend (61% of total). We are factoringin Rs 7.1tn of budgetary support, which is ~1.6% of GDP in that period. In termsof debt funding, we estimate requirement of Rs 14tn across the private sector,centre, and state (54:34:12).

Debt funding may not be a constraint: Bank credit to infrastructure, as apercentage of total bank credit (non-food), has increased from 8% in FY07 to12.7% in FY10. Even if the share of credit to infrastructure increases by 50bpsevery year over FY10-FY17, bank credit itself can meet 47% of the total debtfunding requirement. The remaining requirement will be met through other debtsources like NBFCs, pension funds, and ECBs.

Private sector share to rise to 39% in 12th plan from 36% in 11th plan: Privatesector share will rise in roads (to 44% in 12th plan from 17% in 11th plan), power(to 51% from 44%) and railways (to 14% from 4%). However, lower spend intelecom (large private sector share but capex peaked out) and lower privatesector share in airports will limit the rise in overall share to 39% in the 12th plan.65% of total spend in power, roads, railways: Power sector will continue toaccount for highest share in the 12th plan spend at 32%. The road segment islikely to see an investment of Rs 4.5tn, 17% of total. Rise in project awardactivity by NHAI will lead to higher investment in national highways. Railwayswill see an investment of Rs 4.5tn over the 12th plan period.

EPC opportunity of ~Rs 12tn: We estimate an EPC opportunity of ~Rs 12tn from12th plan, primarily in sectors such as roads, railways, power, irrigation, andwater supply. This will necessitate ramping up of business by existing players.Key risks: a) Delay in coal availability for power plants; b) delay in road projectawards by NHAI (due to land acquisition, environmental clearances); c) slowexecution by the railway ministry.

Prefer L&T, IVRCL, NCC, Patel Engineering and Ahluwalia Contracts: We expectcompanies within our coverage universe to deliver revenue/earnings CAGR of20%/25% over FY10-FY12E. These companies are set to tap the upcoming EPCand asset development opportunities. We prefer companies with strong cashgeneration, a good execution track record, and reasonable valuations.